Merrill's $5 Billion Bath
Bares Deeper Divide

After Big Write-Down Tied to
Mortgage Debt, O'Neal Asserts Control

RANDALL SMITH / Wall Street Journal 6oct2007

Merrill Lynch & Co.'s announcement Friday that it would take a $5.5 billion hit to third-quarter earnings is exposing the weak oversight exercised by top Merrill executives as it became a big force in the mortgage-securities business.

Subprime Hits

Recently announced losses
tied to the credit crunch:
in billions

$5.0  Merrill Lynch
 3.4  UBS
 3.3  Citgroup
 3.1  Deutsche Bank
 2.4  Morgan Stanley
 1.5  Goldman Sachs
 0.7  Lehman Brothers
 0.7  Bear Stearns

Note: Figures exclude fees
      and other gains.
Source: the companies

Wall Street has been reeling from the recent credit crunch tied to questionable home mortgages, with several companies taking multibillion-dollar write-downs. But Merrill is taking the biggest charge and is the only major U.S. firm so far that has said it will report a loss for the third quarter.

The announcement gave a boost to Merrill's shares, which rose $1.89, or 2.5%, to $76.67 in 4 p.m. trading Friday on the New York Stock Exchange. That reflected investors' relief that Merrill is trying to put the problems behind it. The broader stock market was also higher, with the S&P 500 index hitting an all-time high. The Dow Jones Industrial Average gained 91.70 to 14066.01, just shy of a record.

Merrill Lynch, best known for its symbol of the bull and its "herd" of 16,000 brokers pitching stocks to retail investors, had become deeply involved in the mortgage business by this year. That was despite an assurance to investors just three months ago that its exposure was "limited" and "contained." At one point, Merrill had amassed a portfolio of at least $25 billion in risky assets, people familiar with the situation say.

The ballooning exposure to these assets, which fell in value amid spreading defaults by homeowners, prompted the firm on Wednesday to oust two of its top credit-market executives, Osman Semerci and Dale Lattanzio. The executives believed the crunch was "just a hiccup," but Merrill Chief Executive Stan O'Neal concluded that their estimates of the assets' value were overly optimistic, people familiar with the firm said.

There were cheers and high-fives on the debt trading floor after the exits were announced, says a person who was there.

The ouster was surprising because Mr. O'Neal and one of his top executives, Ahmass Fakahany, had been seen within the firm as big backers of Mr. Semerci. The two ousted executives oversaw collateralized debt obligations, which are securities backed by pools of mortgages and other assets. Their group got "caught out" with a large position in these securities in a "game of musical chairs," said someone familiar with the firm. Mr. O'Neal lost confidence in the executives' ability to manage the business, said another person close to the firm.

In a brief interview, Mr. Semerci disputed a suggestion that he had placed a greater emphasis on market share than on risk controls. He declined to comment on how the securities should be valued. Mr. Lattanzio couldn't be reached for comment.

In a statement Friday, Mr. O'Neal said that "while market conditions were extremely difficult and the degree of sustained dislocation unprecedented, we are disappointed in our performance in structured finance and mortgages." In a 20-minute video message to Merrill employees yesterday, Mr. O'Neal accepted a share of the blame for the losses, saying, "I missed it."

In July, before the market worsened, Merrill's chief financial officer, Jeff Edwards, said in a conference call with investors that the firm's exposure to subprime mortgages was "limited, contained and appropriate." These mortgages are typically made to borrowers with poor credit records, and their value has plunged this year.

"This is a black eye," said analyst Michael Mayo of Deutsche Bank AG. "There's no free pass for a $5 billion write-down. It shows they could have been more conservative in writing this down all along."

Credit-rating agencies maintained Merrill Lynch's current credit ratings but revised the outlook to negative. Standard & Poor's said Friday's announcement "raises concerns over Merrill Lynch's risk-management practices in allowing such a large exposure to build." A lower credit rating can increase a company's borrowing costs.

Merrill's earnings warning brought to nearly $20 billion the total amount of write-downs recorded by major banks and securities firms including Merrill, Lehman Brothers Holdings Inc., Morgan Stanley, Goldman Sachs Group Inc., Citigroup Inc., UBS AG, Deutsche Bank and Bear Stearns Cos.

The actual losses are even greater because they have been reported after fees, offsetting hedges and gains recorded by the financial firms due to declines in the value of their own debt. At Merrill, the bulk of the $5.5 billion hit was a $4.5 billion write-down, after offsetting hedges, on collateralized debt obligations and subprime mortgages. The remaining $967 million, which was reduced to $463 million by offsetting fees, reflected losses on loan commitments for buyouts.

Merrill wasn't able to trade its way out of its problems, analysts noted, because it was one of the biggest creators of CDOs. These instruments are created by buying various kinds of debt -- often risky mortgage-backed securities -- pooling them together and using them to back the issuance of new bonds. The bonds, which are sold to investors, come with different levels of risk and return.

As the biggest seller of CDOs, Merrill had bought a large amount of mortgage securities and built a "warehouse" of them. To add capacity, Merrill paid $1.3 billion in January for subprime-mortgage originator First Franklin Corp., a deal which Mr. O'Neal conceded Friday was poorly timed.

The write-down means Merrill will report a loss of about $450 million, or 50 cents a share, for the third quarter, after showing quarterly operating profits averaging over $2.1 billion for the past four quarters. This means Merrill's earnings will likely decline from $7.57 billion for 2006, not counting charges, but should still top the $5.1 billion level of 2005.

Mr. O'Neal said he believed the losses are "contained," and the firm needs to take such risks to serve clients and generate shareholder returns. Merrill has strengthened its risk controls, he added, and doesn't plan a broad retreat from credit markets or major job cuts.

It was the big push into CDOs -- combined with some personnel changes last year -- that led Merrill astray, according to firm executives. Merrill, which had a small share of CDO underwriting before 2003, revved up the business that year and rose to the No. 1 spot from 2004 through this year. Its annual CDO underwriting volume swelled to $52.4 billion in 2006 from $1.5 billion in 2002, according to Dealogic, a data provider. More than two-thirds of the 2006 volume comprised CDOs backed by subprime-mortgage bonds.

Fees on such deals typically total about 1.25% to 1.5% of the face value of the debt, which would bring Merrill's estimated fees for 2006 on such deals to roughly $700 million. Merrill was holding assets for over two dozen pending CDOs when the market for subprime mortgage bonds began turning south earlier this year, according to a person familiar with the matter.

Prices for subprime mortgage bonds and mortgage CDOs have dived by 5% to 60% since February, with much of the decline taking place this summer after investor demand for them dried up.

Some insiders say the departure of Jeff Kronthal, who oversaw credit, real estate and structured products at Merrill until his July 2006 ouster, may have contributed to the firm's problems. In addition to opposing the First Franklin purchase, Mr. Kronthal worried that Merrill's exposure to CDOs was too great, according to people familiar with the matter.

After Mr. Kronthal's departure, these people said, Mr. Semerci and his CDO team, led by Mr. Lattanzio, continued amassing the risky assets, these people said, and didn't back down even when demand ebbed earlier this year. In internal conversations with senior Merrill executives this year, Messrs. Semerci and Lattanzio argued against major markdowns in the value of the assets.

But after the market turmoil, Merrill decided to value the assets at seriously depressed market prices. That created bigger losses than Merrill's senior executives had anticipated. The new valuations in many cases were lower than what Messrs. Semerci and Lattanzio believed was necessary.

Mr. Semerci at one time worked in Tokyo and reported to Dow Kim, who ran Merrill's capital-markets division there and went on to become co-head of Merrill's institutional-securities division. But in May, Mr. Kim announced plans to resign, and Mr. O'Neal named the other co-head, Gregory Fleming, to become co-president along with Mr. Fakahany.

With Mr. Kim departing, Mr. Semerci lost a strong source of top-management support. This past week, when the two fixed-income executives were ousted, Mr. Kim was told to vacate the Merrill office he had been using.

--David Reilly and Serena Ng contributed to this article.

source: p.A1 6oct2007